The Commoditization Conundrum

The Commoditization Conundrum

It isn't pure competition but the fear of it that drives companies to compete.

If there's one thing that microeconomics has demonstrated, it is that it's hard to keep your profit margins high if you're in the wheat-growing business. Wheat is pretty much wheat, no matter where it grows, and it's pretty easy to grow unless the Dust Bowl is raging. That means that the supply of wheat rises quickly to meet demand, which, in turn, keeps a downward pressure on prices. Wheat, in other words, is the definition of a commodity, and the market for wheat--absent government intervention--is about as close to perfect competition as you can imagine.

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The same would be true, one might think, of salt. If anything, salt is easier to produce than wheat. And salt is the same all around the world. It should, in theory, be impossible for a company to charge more for its basic salt than its competitors do. And yet, Morton actually owns nearly half the American salt market, even though its salt is more expensive--at least a few pennies more--than other brands. If salt is a commodity, and surely it is, then American consumers appear not to know it.

The lesson of Morton's success, obviously, is that even the most mundane and undifferentiated of products can be made into something unique with the right marketing strategy. Salt is salt is salt, except when it comes in a blue canister with a little girl with an umbrella on it and the promise that rain won't damage its pourability. Yet what's striking about American business today--and in particular about the very industries that we now think of as the heart of our economy, namely information technology and financial services--is that the people in charge are not consoled by the thought of Morton's successful "branding." Instead, they are haunted by the specter of that wheat market. Luckily for them, though, we're much further from that world of perfect competition than much recent hype would suggest.

What corporations fear is the phenomenon now known, rather inelegantly, as "commoditization." What the term means is simply the conversion of the market for a given product into a commodity market, which is characterized by declining prices and profit margins, increasing competition, and lowered barriers to entry. ("Commoditization" is therefore different from "commodification," the word cultural critics use to decry the corruption of higher goods by commercial values. Microprocessors are commoditized. Love is commodified.)

W ithout this fear, corporate America should be in its heyday. Profits and stock prices are at record highs, and there's no sign of any meaningful challenge--regulatory or otherwise. But analyses of the prospects for the personal-computer industry or the banking industry or even the clothing industry reveal a permanent anxiety. What companies rely on for profits today they assume will most likely not be there tomorrow, because tomorrow someone else will be making the very same thing for less. (Click for one recent, emblematic account.) In this universe, even the paranoid may not survive.

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Insofar as commoditization is a reality, it's all to the good for consumers. It is witness to the enormous distance U.S. corporations have traveled from the inefficiencies and quality-control debacles of the 1970s. Commoditization can only take place, after all, in a world in which second-tier companies can compete in terms of quality and efficiency with top-of-the-line companies. And commoditization, or at least the fear of it, encourages innovation. Those technological breakthroughs that allow a company to distinguish itself from its competition and charge a premium for its product are more likely and fruitful in an economy characterized by price competition than in one dominated by oligopolies. Finally, and perhaps more dubiously, commoditization has furthered the democratization of fashion and interior decoration. Whether you deplore or welcome the Gap-ification of America, it is happening.

Still, this supposed ubiquity of commoditization is difficult to square with one fact: A few large corporations dominate many, if not most, major U.S. industries. From Coke and Pepsi to Compaq, Hewlett-Packard, and Dell, to Intel to Gillette, companies have been able to maintain high profit margins and market share in businesses that, in theory at least, should be eminently susceptible to competition.

In some cases, with the auto industry being the best example, commoditization has been fended off by the enormous capital investment required to enter the business. It takes a much smaller initial investment to make a new word-processing program than it does to build a car. In other cases, like the soft-drink industry, a curious confluence of taste distinctions and brand identification makes meaningful challenges difficult to imagine. Coke does taste different from Pepsi and RC, but that taste difference is reinforced by the all-American mythology that has been wrapped around it. In still other cases--the personal-computer industry, for example--the brand name becomes a kind of surrogate for quality and reliability. It's possible, even likely, that XYZ Computer makes a PC every bit as good as Compaq's. But because I recognize Compaq's name, I'll buy its PC without bothering to check out what XYZ is offering. If I pay extra for Compaq (which I probably won't have to), it's to cover the opportunity cost I avoid by not having to comparison shop.

T he greatest example of a company avoiding seemingly certain commoditization is Intel, which continues to charge premium prices for its microprocessors even though, by all accounts, its Pentium chips are no more powerful than chips made by Intel's two main competitors, Advanced Micro Devices and Cyrix. It's true that Intel's production lines have been consistently more reliable and efficient than either AMD's or Cyrix's. That makes PC manufacturers more comfortable putting Intel chips in their computers. But other factors contribute to Intel's success. The mere fact of its commanding position in the microprocessor market--a position it initially achieved by technological superiority--has made computer makers leery of doing business with its competitors, lest Intel fail to give them access to new, more powerful chips in the future.

More strikingly, Intel's successful "Intel Inside" ad campaign has created a brand name for a product that observers once believed was the very definition of a commodity. As one less-than-prescient ad exec put it in 1991 while labeling Intel's advertising efforts "awfully stupid": "Most people that buy computers don't even know that that chip is in there. They care about the performance of the computer. It really doesn't matter what the chip is." Oh well. Cyrix and AMD are now spending millions of dollars on TV-ad campaigns in recognition of the fact that it really does matter.

More intriguing than Intel's success, though, is the continued market domination of companies like Gillette and Campbell's soup. While Gillette's razors are technologically superior to Schick's and Campbell's soup tastes better than its competitors', the quality differences aren't big enough to account for these companies' ability to combine premium pricing with huge sales. (Gillette owns 67 percent of the U.S. razor market, and Campbell's has more than 75 percent of the U.S. soup market.) Nor can we simply ascribe their market dominance to advertising. What's going on seems to be something we might describe as "the narcissism of small differences." In an odd way, the more similar products become, the more telling the little differences among them end up being. Branding successfully, in other words, can turn a small difference between products into a huge difference in market share.

None of this means that Gillette and Campbell's are not pushed by their competition, since all the evidence suggests that they are constantly looking for competitive advantages. What it does mean, though, is that commoditization does its work not by becoming a reality (which would entail ever-shrinking margins and stagnant stock prices) but by remaining a perpetually present threat. It's the idea that perfect competition might be just around the corner, not the competition itself, that keeps the paranoid prosperous. And alive.